True Value

By

Rhonda Brammer

Updated Oct. 8, 2001 12:01 a.m. ET

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Einstein was right. Everything is relative. And in this year's treacherous stock market, small caps have been the place to be. Not that you've made money, of course. You've just suffered less, probably a good deal less. While large stocks, for example, as measured by the S&P 500, have declined 19% so far this year, the S&P 600 SmallCap index is down a considerably more moderate 10%.

Odds are, moreover, that small caps may well outperform the rest of the market in the months ahead. For the multiple on small stocks is roughly half that sported by large stocks, or 14.8 compared with 28.3, reports Minneapolis-based Leuthold Group. That's the sharpest discount to big caps in nearly three decades. So it's quite likely that the difference in P/Es between big and little will narrow in the months ahead.

Also strongly suggesting that the spread will shrink is that small caps have been acting so much better, not only giving less ground than their bigger brethren on bad days, but shooting up more vigorously on good days. In Wednesday's spirited rally, for example, while the S&P 500 gained 2.0%, the S&P 600 SmallCap index advanced 3.3%.

But there are small-cap stocks and small-cap stocks. And small-cap value stocks, it turns out, have vastly outpaced small growth stocks, as the accompanying chart illustrates. The Russell 2000 ended the third quarter down 16%, which compares favorably with the 21% decline in the S&P 500. However, during that span, the Russell 2000 growth index dropped a whopping 28%. By contrast -- and here's the critical point -- the Russell 2000 value index lost a mere 4%.

So, to repeat, for the congenital stock lover -- the gal or guy who can't say no to stocks regardless of what the world, the economy or the market is doing -- small-cap value shares are the once and future best place to be.

All well and good to declare small-cap value stocks as the investor's best hope. But to make the big leap from generality to the particular, to pinpoint the issues that look most promising, we turned to a value manager we know -- who's smart and rich (though publicity shy). You'll have to take our word for the fact that he's rich. That he's smart, though, is evident in his performance: For the first nine months of the year, his accounts are up more than 20%.

He'd been very cautious on the market long before the World Trade Center disaster, with about 30% of his portfolio in cash and Treasuries. Almost another 30% was invested in oil refiners, both their junk-bond debt as well as equity stakes in outfits such as
Frontier Oil,
which he started buying at 3 and whose shares recently topped 20.

Besides a sharp eye for bargains and vast patience, his investment virtues include an abiding respect for risk. It's no surprise, then, that he remains wary.

"You've got to be very careful in this market," he insists, noting that he has deep misgivings about how the sudden, sharp contraction in business activity after the terrorist attacks will play out. "The next couple of years could be fairly unpleasant," he says.

Accordingly, high up among his priorities for buying companies is to be sure they "will be around two years from now" -- companies with meaningful franchises and decent balance sheets. Case in point:
Visteon,
the auto-parts supplier spun out of
Ford
last year. Its shares traded above 21 in August, but now can be had for around 13, giving the company a stock-market value of $1.7 billion.

Two months ago the company was hailed -- and not without reason -- as a long-term restructuring play. The idea was simple: Once separate from Ford, which last year chipped in 84% of revenues, the company could gradually jettison less-profitable business, while it streamlined operations, slashed costs and expanded sales to other auto makers. Compelling, too: Even at its peak, Visteon was valued at roughly half that of its rivals.

But by September, even before the terrorist attacks, the stock had slumped to 16 on news of production cuts at Ford. Then, on September 21, with an indication that Visteon would open between 9 and 11, our pal bid 9 and change for 100,000 shares. The stock opened well above 10, so he still doesn't own a share. "It's a very cheap stock," he shrugs, "but my idea is to buy it at 10."

For a somewhat less disciplined investor, though, or one with a more cheerful view of the market, even at 13 and change, Visteon looks intriguing at a mere at 9% of last year's sales and only half of tangible book value. Cash and securities roughly equal long-term debt.

The immediate earnings outlook, of course, is somewhere between terrible and awful. First Call expects the company to earn 32 cents a share this year, down from last year's $2.80. That's a more optimistic expectation than our pal, who thinks the company probably won't make money this year.

That said, Visteon is the world's second-largest maker of auto parts and, our friend believes, clearly a survivor. What's more, it's a company that boasts tremendous earning power -- over $5 a share, he insists, noting that pro forma Visteon earned $5.41 a share in '98 and $5.65 in '99.

At 13-plus, an investor is paying 2.7 times peak earnings. Two or three years from now, peak earnings of $5 should command a multiple of at least 6, putting the stock at 30.

Getting there could take a while, but the potential sounds worth the wait.

What prompted his recitation was that his large- and mid-cap portfolio and his small-cap portfolio ended the nine-month mark down 9% and 6.8%, respectively. That's a heck of a lot better than the 16% and 21% declines in the Russell 2000 and S&P 500, but Scott hates losing money and he's frankly worried the market may still be in for some tough sledding.

Even if S&P earnings come in at $55 next year -- "a very generous estimate" -- the market's expensive at 19.5 times those estimated earnings. The S&P yield is a scarcely ample 1.5%. "And there's a lot of political risk," he argues. If President Bush fails to respond quickly and effectively to the Taliban and bin Laden, "it will have an enormously deleterious effect on consumer confidence."

No market timer, Scott is doughtily accumulating what he thinks are decent businesses at bargain prices. One of the more interesting stocks he bought last week -- for the risk-averse investor, anyway -- was
Sovran Self Storage.

It sells at 1.1 times tangible book and yields almost 9%.

Based in Buffalo, New York, Sovran's market cap is about $300 million, though it is the country's fifth-largest storage company, with some 230 centers in the Eastern U.S. and Texas operated under the Uncle Bob's trademark.

"Business is holding up nicely," Sovran management told Scott last week, adding that it had seen no impact from September 11.

Like most real-estate investment trusts, the company is leveraged, but Scott notes that in the second quarter, earnings before interest, taxes, depreciation and amortization was running a comfortable four times interest expense.

He expects the company to earn $3 or so a share this year (for REITs, that's funds from operations), up from last year's $2.81. So at $26.70, the stock is selling under nine times FFO. The dividend is $2.36 a share, for a yield of 8.8%. Scott reckons Sovran's break-up value, moreover, is north of $30 a share.

Same-store sales and net operating income grew just over 4% in the most recent quarter, but over the next three-to-five years, he says, it should run 5%-6%.

"So you're getting a total return of 14%-15%," he shrugs. "In this market, that isn't the worst thing in the world." It sure isn't.

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